Why chasing dividends is a mistake

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(MoneyWatch) Many investors prefer dividend-paying stocks, especially people who take an income, or cash flow, approach to investing -- as opposed to a total return approach, which I believe is the right approach. However, new research from Dimensional Fund Advisors shows that investors who expect dividends to protect them in tough times might be in for a rude awakening (Disclosure: My firm, Buckingham Asset Management, primarily uses DFA funds in constructing client portfolios.)

The current era of historically very low yields on safe bonds has attracted many new adherents to the strategy of favoring dividend-paying stocks, especially the stocks of companies with either high or rapidly growing dividends.

Today, we'll take a look at the findings of a March 2013 study, "Global Dividend-Paying Stocks: A Recent History," produced by the research team at DFA. The study covered 23 developed markets over the period 1991-2012.

Returns

According to the analysis, the average annual returns were 9.1 percent for dividend-paying stocks and 11.1 percent for nonpayers. However, the returns of nonpayers were more volatile than for dividend payers. The net result was that the annualized returns were the same 7.6 percent. However, by focusing on only dividend payers, an investor would exclude about 40 percent of firms, thereby sacrificing some diversification benefit.

Vanishing dividends

The propensity of firms to pay dividends has shown a global decline. The percentage of firms paying dividends globally dropped from 71 percent in 1991 to 61 percent in 2012, with declines occurring in both U.S. and international markets. Thus, a dividend-paying strategy has become less and less diversified. In 1991, creating a portfolio that captured 50 percent of global dividends required about 320 companies. By 2012, that figure had dropped to just 220. By comparison, the Vanguard Total Stock Market Index Fund (VTSMX) had more than 3,200 stocks at the end of February, and the Vanguard Total International Stock Index Fund (VGTSX) had more than 6,100 stocks.

Although less volatile than the capital gain component of stock returns, the aggregate stream of dividend payments is subject to the same broad, macroeconomic risks that affect capital gains. For example, in 2009, 14 percent of firms around the world eliminated their dividend, and 43 percent reduced their dividend.

The evidence makes clear that there are no advantages in terms of returns to a strategy of investing in dividend-paying stocks. In addition, such a strategy sacrifices diversification benefits. More importantly, as we have shown in prior posts, neither a strategy of investing in high-yielding stocks or the stocks of companies that have shown a high growth in dividends has proven to be an efficient means of improving returns.

Investors who seek higher returns are better served by investing in value-oriented strategies -- strategies that focus on the stocks of companies with low prices relative to earnings, book value, sales and/or cash flow. Those all have provided higher returns than a strategy of investing in companies with a low price relative to dividends. Not only have those strategies produced higher returns, they have done so while also producing a higher Sharpe ratio (higher risk-adjusted return).

Also keep in mind that for taxable investors, dividends are less tax-efficient than capital gains. (They cause you to pay taxes sooner and can increase the adjusted gross income past the threshold for the 3.8 percent net investment tax.) And in tax advantaged accounts you lose the benefit of the foreign tax credit.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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